Floating Democrats, Dollars and Oil Jude Wanniski January 23, 2004

If you slogged your way through the New Hampshire Democratic presidential debate last night, you may have noted ABC's Peter Jennings asked the first question about monetary policy in the countless debates stretching back to last summer. He posed his question about Fed policy to Al Sharpton, who thought the question was about the IMF, and when Jennings corrected him, Sharpton mumbled a non-answer and said he did not have anyone in mind to replace Alan Greenspan as chairman. If he had asked any of the other candidates, he probably would not have gotten a much different answer. Jennings should at least have asked the new Democratic frontrunner, Senator John Kerry, about his views on the Fed to get a discussion going, which will not happen as a result of Sharpton's fumblings. The Democrats are as much afloat on monetary matters as the White House and the GOP. Yet monetary policy more than ever is critical to the near future of the U.S. and world economy, particularly bearing on the supply of oil and its price in dollars.

 

This morning’s Wall Street Journal reported that the major oil companies have been "significantly less successful at discovering petroleum than recent regulatory filings suggest," according to a new report by energy consultant Wood Mackenzie. The report paints a dismal picture of the oil industry's recent exploration performance. It also raises questions about the usefulness of the Securities and Exchange Commission's guidelines for reporting reserve estimates at a time when those numbers already are under scrutiny after Royal Dutch/Shell Group slashed its tally of oil and natural gas reserves by 20% earlier this month.” This is a story we have been watching closely because it is directly related to the monetary deflation Polyconomics was practically alone in warning about in 1997, when it began to unfold with the long slide in the dollar/gold price. When the dollar/gold price slid right behind gold, at one point trading under $10/bbl., the world oil industry simply decided to stop exploring. The 10 largest oil companies reported combined discoveries of 13 billion barrels in 2000, reflecting investment decision made before the oil price decline. In 2001, the number dropped to 4 billion barrels and then to 3.34 billion barrels in 2002.

 

With gold climbing back to $430/oz earlier this month from its low of $255 in April 2001, oil is back over $35/bbl. and the world rig count is running at levels not seen in 15 years, but the depletion rate still is outpacing the discovery rate. Much of this is the industry’s wariness of betting big bucks when the dollar/oil price could run in any direction given the vagaries of Fed dollar policy. The WSJ reported that John Felmy, chief economist at the American Petroleum Institute, said companies were challenged by fluctuating oil prices from year to year that can affect exploration spending and new finds. "Given the very low oil prices in 1999 and lags between spending decisions and results, 'it doesn't strike me as unusual that you`d see this decline,' he said."

 

The immediate problem for the U.S. economy is the weak dollar, which should be strong enough to buy gold at $350/oz. in order to anchor oil close to its equilibrium price with gold at that level, which would be around $25/bbl. At $35/bbl, OPEC oil producers have little incentive to tap into their reserves to hold down the price. Nor is there any pressure from Europe, where the euro/gold price has held steady during the last four years, which shows the value of that anchor. The euro/oil price at €27 bbl is about the same as where it was in January 2000. Our financial press does not notice these connections, but the OPEC world surely does. Mahathir Mohammed, the former prime minister of Malaysia, early this week urged the Arab countries to begin pricing their oil in gold, or at least in a currency that holds its value relative to gold. Mahathir still is at work in the Islamic world trying to promote a gold dinar to compete with the euro and the dollar. As we also have been alone in pointing out, the Patriot Act’s provisions requiring banks to report all major dollar transactions that might lead to terrorists is probably helping weaken the demand for dollar liquidity in international commodity markets.

 

In the mid- and longer term, there is the problem of a world economy growing at rates that demand oil in ever-increasing volumes. George Yates, a former president of the Independent Petroleum Association of America and a longtime Poly client, says there will be additional supplies of oil coming to market in the next year from non-OPEC countries, “but that should be absorbed by the market without causing OPEC a lot of problems. In the longer term, we are going to have to replace depletion from declining giant fields found 50 to 70 years ago that until recently have shown no decline. The industry is going to have to work very hard to meet future demand, including replacement of depletion.” World production, which now is roughly 75 million bbl./day, will have to add enough capacity to produce another 40 million bbl/day within the next 10 years! Yates says the rig count has to be put into this context. He also worries that there remains a lack of transparency in production/reserve information worldwide so we can`t fix on a worldwide depletion number. "Given the magnitude of the task of bringing large new supplies to market, I see no reason why the old ratio with gold will be a good fit in the future."

 

The ratio of oil to gold had been fairly steady at 13 bbl./oz. gold before the U.S. left the gold standard in 1971. Since 1971, the moving average has been 16.2/1. With the scarcities fostered by the monetary deflation, the disruption of oil supplies in Iraq and the booming demand for oil by the 2.2 billion people in China and the Indian subcontinent, an ounce of gold now buys only 11 barrels of oil. The oil/gold ratio eventually will come back into balance, the way the ratio of apples to oranges never stays out of whack for extended periods. The oil/gold balance will come about naturally over a longer stretch, but this would have to be preceded by the U.S. re-fixing the dollar/gold price and requiring the Fed to stop fiddling with the Phillips Curve, the output gap and irrational exuberance as monetary guides. The European Central Bank providing a euro/gold anchor and the world energy industry abandoning the dollar as its unit of account could also precede it. It also means that China, India and other relatively unexplored countries would find ways to encourage domestic wildcatting. For China, this would mean transferring state lands to private ownership. It is bound to happen around the world -- where all governments still control the mineral rights to state or private property. It might take decades, but energy demands of an affluent world will demand it.

 

Of course, there are also the energy alternatives. Gordon Prather, the nuclear physicist who worked for the Federal Energy Administration in the Nixon/Ford years, believes by mid-century almost everything in this country that does not move ought to be running on electricity generated by nuclear power plants. And almost everything that does move ought to be running on methanol. These are the easiest energy solutions, as both sources are for all practical purposes inexhaustible and within economic reach. Why are we not moving in that direction? This brings us back to our floating politicians in both political parties, with the GOP aligned with the oil industry and the Democrats aligned with the environmentalists, with both parties under the thumb of the Iowa caucuses and the ethanol lobby. This also will change, when the pinch of global oil depletion is felt more keenly than it is today. Meanwhile, the cold snap in the Northeast has me turning up the heat with natural gas selling at $7 mcf, when it should be no more than $4 to $5.

 

As for the tax side of the New Hampshire debates, where all the candidates are sure they want to repeal all or some of the Bush tax cuts, there is nothing to worry about. Even if one or another makes it to the Oval Office, Congress will not let them do it.

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